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The language of investing

I have a friend who has described investing to me as similar to learning a language. At first you start by translating a word or two at a time, then you attempt to piece together simple meanings. Eventually with enough practice you can read and speak complete sentences and convey thoughts in the new language. Investing is similar in many regards.

There have been a number of studies that have "proved" that investing in low anything (EV/EBITDA, P/E, BV) and recycling the portfolio result in superior returns. Mechanical approaches like this and other approaches such as investing in mutual funds, or ETFs are what I would consider the beginner level of learning a language. The investor buying their first ETF is akin to someone learning that "hola" means "hello". There is nothing wrong with only being able to say a few words in a language, and many people never progress beyond learning some simple salutations and other basic words. For many investors just knowing the beginning words are enough, returns will be satisfactory. Many never have an interest in learning a second language, or becoming a full fledged investor.

I think many investors are stuck between knowing the basics of a language of being fluent. Fluency is a moving target, and it doesn't mean knowing the entirely of a language. This past winter while skiing in Utah I stayed with my cousin. One night we went out with some of his friends, one who is a Spanish teacher in Salt Lake City. I asked him about being a language teacher and how he taught Spanish; his answer surprised me. He said he doesn't just teach words or phrases, but teaches abstract thinking and reasoning. He said language learning isn't about knowing words and their meanings, it's about knowing context and knowing what words to use when. The same word placed in two sentences can mean different things, a fluent speaker knows and understands this. But someone learning a language struggles and in place of reasoning tries to learn rules. Language rules are complex and almost infinite. Nothing is consistent. My four year old son struggles with putting some words in the past tense. He will say he "digged" a hole. The "ed" isn't the appropriate past tense for dig, yet for the word "type" adding an "ed" is the appropriate way to place it in the past tense. Language evolves as people use it, which means the rules evolve with usage.

Investing rules are no simpler or easier than language rules. Excess cash on a balance sheet might be a good thing for one company, but a negative at another. A low P/E ratio doesn't always indicate that a company is selling at a low multiple of their earnings, it might be a cyclical at the top. Even something simple like revenue can mean multiple things. The right type of revenue that's high margin and serviceable is good. But low margin or negative margin revenue is bad.

As an investor starting out learning how to invest navigating financial statements can be daunting. Subtleties caught by an experienced investor can be missed by a novice. Likewise sometimes experts get caught up with the grammar of investing. I love listening to quarterly conference calls where analysts spend most of their time asking investing grammar questions. You'll hear questions such as "Just to clarify, was the quarterly spend on dixie cups for the office kitchen up 1.2% or 1.17%?" It's easy to get lost in the weeds. I remember reading a conference transcript about a year ago, the company was losing money and clearly needed a turnaround. Analysts were asking minutia questions and debating investing grammar with the executives. Then a retail investor was allowed to talk and asked the obvious, why was the company failing, and when would it be fixed? Sometimes we need clarity like that.

Moving from rules based investing to something more fluent means moving towards a system with a lot of gray, and not much black and white. To do this an investor needs to learn the context of the company and then within that context make decisions about their valuation from their financial statements. Getting to this level is to become fluent in the language of investing. What will start to happen is the clunky translation rules that were relied on originally will start to be forgotten.

When an investor becomes fluent in the language of investing they also develop a style. This is similar to a writer in a natural language. Different writers have different styles. Even when one writer tries to emulate another their own style shines through. I think this is why it's so hard to classify investors. As we learn and become fluent we develop our own styles. There are certain types of companies I like to own, but it's hard to define exactly what those are. Yet when I see one that fits my style I know right away that I want to own it.

The goal for investors should be to become fluent in the language of investing. From that you will develop your own investing style. It's alright if it's not the exact same as a famous investors, no one is a copy of anyone else. The only way to become fluent and develop a style is to start investing and practice.

13 comments:

Nate, this simple post is definitely the best general investment reflection/insight you have had in the last 3 years or so. The other reflections pale in comparison. The analogy is excellent. Well done.

I agree, great post. I second you observation regarding conference call questions. A lot of them are about minutia that have little to do with an investment thesis. I remember on CC transcript where an analyst asked about a cost estimate for an new initiative to fix customer service issues. The founder was evasive about that and basically stated that it takes what it takes. The analyst in desperation just said : " We are here to get numbers to plug in our models!", which says really all you need to know about the motiviation behind those analyst questions.

Very well said, I will be pointing to your article in the future. On a few occasions, I have tried explaining why a stock is undervalued only to receive feedback that the stock is risky for that exact reason.

I am a value investor and I have been following your blog. I would like to congratulate you for your analysis they have been very helpfulI invested in a company that semms to be bargain, although I would like to have your opinion.

AUSTRALIAN VINTAGE LTD (AVG)The company produces and exports bulk and bottled wine, and is the second largest vineyard owner and manager in AustraliaP/E forward: 6;p/B: 30% (a net-net stock);Although the margins, ROE, RIC are very low and the demand for wine has been decresing in important markets, like china.

I made the investment considering the amasing multiples (p/b, p/e) but the margins are not a great indicator.Can you give me your opinion?

great article. I think the more u know about investing the more it is about understanding competitive situations and less about numbers and simplistic valuation tools (learning words in your metaphor).